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What the central banks are afraid of: that the impact of lower oil prices on inflation is not transitory

The essential

The decline in oil prices is mechanically lowering inflation. The key issue is whether the impact on inflation will be temporary or permanent.

Due to the lack of upward pressure on wages, the impact of lower oil prices on inflation could be permanent, which explains the lower long-term inflation expectations.




The precipitous decline in oil prices since summer 2014 has lowered inflation almost everywhere in the world. Headline inflation has gone into negative territory in the eurozone, hit 0.5% in the United Kingdom, and dipped below 1% in the United States. The impact of falling oil prices is mechanically high, with energy making up 10% (more or less) of the basket of consumer goods in the developed countries. Along with food prices, energy prices are considered volatile, and the central banks usually prefer to consider “core inflation,” i.e. inflation ex food and energy, which is supposedly a better reflection of the state of the economy, through tensions on the labour market. According to this logic, and assuming oil prices stabilise at current levels, the impact of lower oil prices on inflation should be only “temporary” and should not be a problem for the central banks. However, doubt is entirely permissible.

The BoE’s case in point. Take the example of the Bank of England (BoE): while two of the nine members of the MPC (McCafferty and Weale) voted for a rate hike at the last five MPCs in 2014, and despite rather decent activity figures in the United Kingdom, they stopped asking for tightening at the MPC in January 2015. Why did the BoE’s hawks back down? Minutes from January’s MPC explain that the BoE is actually separating the outlook for short-term inflation (which oil is dragging down directly) from that of medium-term inflation. The BoE felt “it was possible that the fall in near-term inflation might become more persistent if it lowered inflation expectations, pay and other cost growth in a way that became self-perpetuating,” and that it was “possible that the pace of nominal wage growth would be weaker than otherwise and that this would feed into lower subsequent price inflation.” The MPC’s two hawks said there was a “risk that low inflation might persist for longer than the temporary factors implied and concluded that this risk would be increased by an increase in Bank Rate at the current juncture.”

The transitory nature of the oil price decline is in question when wage dynamics are weak. It is striking to see that long-term inflation expectations have fallen along with oil prices. Five-year breakeven inflation is negative in Germany and around 1% in the United States. As Ben Bernanke explained a few years ago “Inflation expectations and inflation forecasting,” 2007), a one-time change in energy prices does not morph into permanent inflation unless it leads to a change in inflation expectations and influences the interaction between prices and wages. In other words, oil does not have an impact on core inflation when inflation expectations are firmly entrenched. This is just the problem that the developed countries’ central banks are facing, with inordinate inflation expectations compared to the Great Moderation period. In most of the developed countries, and even those where unemployment has fallen considerably, wage inflation is expected, and the debate is still raging over the quantity of slack on the labour market. In an economy where companies no longer feel any pressure to raise wages but rather to find new outlets, it is entirely possible that the decline in oil prices will be passed on their sales prices.

The debate may reach the Fed. In mid-January, Boston Fed Chair Eric Rosengren acknowledged there was a disconnect between the Fed’s confidence in inflation rising in the medium term and the market’s doubts, and that he himself was “not particularly confident” that inflation would come back to its 2% target, stressing weak wage inflation. Mr Rosengren implied that NAIRU11 in the US was low – much lower than general estimates, which would mean that more “patience” is called for before the Fed funds rate is increased.


1 The NAIRU stands for Non-Accelerating Inflation Rate of Unemployment. Inflation accelerates when the unemployment rate falls below this level, as there is pressure on wages in this situation.


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The transitory nature of the oil price decline is in question when wage dynamics are weak 

DOISY Nicolas , Strategy and Economic Research at Amundi
DRUT Bastien , Fixed Income and FX Strategy
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What the central banks are afraid of: that the impact of lower oil prices on inflation is not transitory
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